The PHC trap. (personal holding company) (Federal Taxation)

by Cuiffo, Donna-Marie

Abstract- Closely-held corporations (CHCs) must take measures in order to avoid being categorized as personal holding companies (PHCs). If they are treated as PHCs, these companies would have to pay 28% of the undistributed PHC income aside from the regular corporate income tax. Companies may use two tests to determine their status. They are the stock ownership test and the gross income test. To avoid being snared into the PHC trap, taxpayers may simply disqualify the corporation under either one of the two categories. If this procedure does not prove to be effective, the corporation may pay year-end dividends to avoid the PHC tax. Another way out is the relief provision that allows payment of a deficiency dividend if a PHC tax deficiency is discovered.

The personal holding company provisions were originally intended to
prevent individual taxpayers from using closely-held corporations to
avoid individual income taxes on investment and other specific types of
income. This used to be a very appealing situation when the top
individual tax rate was significantly higher than the top corporate
rate. After TRA 86, the tax rate advantage was lost since the top
individual rate became lower than the top corporate rate. However, it
should be remembered that the lowest corporate rate (15%) is
substantially lower than the top individual rate (31%). Special care
should be taken when working with CHCs set up for other than investment
reasons because unsuspecting practitioners can get caught in the PHC
trap.

The Rules to Be a PHC

Each C corporation is responsible for determining whether it is a
personal holding company. A schedule PH must be attached to the PHC's
return. If the schedule is not filed, the statute of limitations on the
assessment of PHC tax is extended from the usual three years to six
years.

A PHC is subject to the regular corporate income tax plus an additional
tax of 28% of the undistributed personal holding company income. Since
these tax liabilities could become substantial, the taxpayer and its
advisors should review each CHC before year end so that steps may be
taken to assure that the corporation does not owe the personal holding
company tax.

Example. The rental of a commercial building is the sole business of a
newly formed closely-held corporation. For the first three years, the
corporation reported a loss from the activity. Due to Sec. 469
limitations, the loss was suspended and carried forward. Therefore, no
net operating loss carryforward exists. In year four, the shareholders
contributed additional money to the corporation for various
improvements. For one reason or another, the improvements were not
started in year four, so the money was put into a brokerage account.
During the year, the corporation earned interest income of $50,000. In
the same year, the rental activity had a net rental loss of $20,000
(rental income of $200,000, property taxes of $30,000, depreciation of
$170,000, and other expenses of $20,000). The corporation did not pay
any dividends during year four. The corporation has a passive rental
real estate loss of $20,000, none of which can be used to offset the
interest income because of the Sec. 469 limitations. The $20,000 passive
loss is suspended and carried forward to future years. The corporation
will pay a regular corporate tax of $7,500 plus a PHC tax of $11,900 on
the $50,000 of interest income. The PHC tax of $11,900 is calculated by
taking 28% of the undistributed PHC income of $42,500 ($50,000 - Federal
tax of $7,500).

How the PHC Tax Operates

There are two criteria for determining whether a C corporation is a PHC:

Stock Ownership Test. Five or fewer persons own more than 50% of the
value of the corporation's stock.

Gross Income Text. At least 60% of the adjusted ordinary gross income is
personal holding company income.

Constructive ownership rules are provided by the IRC to prevent the
avoidance of the stock ownership test by the mere creation of additional
entities. For the gross income test, Sec. 543 refers to the section
defining gross income Sec. 61 for the determination of what constitutes
ordinary gross income.

Adjusted gross income is calculated by making the following adjustments
provided by Sec. 543(b):

1. Rental income is reduced (not below zero) by rent expense, property
taxes, interest and amortization allocable to the rented property, and
depreciation. In our example, the rental income of $200,000 would be
reduced by $30,000 of property taxes and $170,000 of depreciation.
Therefore, the total adjusted ordinary gross income in our example is
$50,000 of interest income.

3. Interest income on judgments, tax refunds, and condemnation awards is
excluded.

Personal holding company income consists of the following:

* Dividends, interest (except as described above), royalties, and
annuities;

* Adjusted income from rents (gross income from rents (with some
limitations) reduced by depreciation, property taxes, interest, and rent
but not in excess of gross rents);

* Adjusted income from mineral, oil, and gas royalties (with some
exceptions);

* Copyright royalties (with exceptions);

* Produced film rents (with exceptions);

* Compensation for the use of property if at any time during the tax
year 25% or more of the corporation's stock is owned, directly or
indirectly, by an individual entitled to the use of the property; and

* Amounts received under a contract for personal services rendered by
an individual who owns 25% or more of the corporation's stock.

Rental income will not be considered PHC income if the rental income
totals at least 50% of adjusted ordinary gross income and the sum of
dividends paid, dividends considered paid, and consent dividends is at
least equal to the amount by which other personal holding company income
exceeds 10% of ordinary gross income.

Since, in our example, PHC income ($50,000 interest income) is more than
60% of adjusted ordinary gross income, the CHC is a PHC. Since no
dividends were paid, it would appear that the corporation has been
caught in the PHC trap.

The Fix

There are ways to correct the situation. The most obvious ways are to
either disqualify the corporation under either the stock ownership test
or the gross income test by deferring or accelerating specific types of
income. Although these methods will result in no PHC tax, they are not
always practical.

Since the PHC tax is assessed on undistributed PHC income, a payment of
a dividend will eliminate the tax. If a projection of taxable income can
be made reasonably accurate, the corporation may take steps to pay
dividends by the year end. If a PHC problem is discovered after year
end, the corporation may still solve the tax problem since the
dividends-paid deduction includes dividends paid on or before the 15th
day of the third month following the end of the tax year. In order for
these "post-year" dividends to be deductible, they may not exceed the
lessor of the undistributed personal holding company income for the
prior tax year or 20% of the dividends paid during the prior tax year.
Therefore, due to the 20% limitation rule, if no dividends were paid
during the prior tax year, no post-year dividends will be deductible.

If the corporation cannot deduct the post-year dividends, it may choose
to have the shareholders file for a consent dividend provided the
consents are filed any time before the due date of the corporation's
income tax return. A consent dividend is an amount the shareholders
agree to report as dividends even though not received by them.

The dividend carryover (the excess of the dividends paid in the prior
two years over the taxable income for such years) may also be considered
as part of the dividend deduction.

If a PHC tax deficiency is assessed because of a bona fide difference of
opinion with the IRS relating to an amount of income or deduction, there
is a relief provision that permits the taxpayer to escape the PHC tax by
the payment of a deficiency dividend. There are certain limitations as
to the application of this relief provision which should be reviewed
carefully. The relief provision is not available if any part of the
deficiency is due to fraud with intent to evade tax or to willfully fail
to file a timely income tax return.

Because of preparer penalties, it is very important to examine each
situation annually. CHCs set up with purposes other than to be
investment conduits must stay alert to the fact that some year they
might be caught in the PHC trap.

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